A lot has happened over the past month and with the half year reporting season almost over, there have been many interesting updates across companies. However I want to focus today discussing two asymmetric opportunities and then a general framework on how to allocate risk towards these types of ideas.
Valaris (VAL) restructuring
Firstly, I have been deathly wrong about international oil rigs since initiating a position in mid 2018 and they have been the single largest detractor from my performance. What had started in 2020 as a promising year of rising rig utilisation and day rates soon turned to hell with the historic collapse in oil demand and prices. Even the top players are having trouble surviving.
I don't allocate money based on hopes and dreams. As detailed in my June post, I cut most of my positions and reallocated towards COSL with a little bit remaining in Transocean.
However a new opportunity presented itself when a few days ago VAL announced it was finally entering Chapter 11. The 8-K effectively said it had come to an agreement with 50% of its bondholders to restructure the company which would basically wipe out all the equity and give the newly restructured company to bondholders and the credit facility providers (the banks). It would get $500m liquidity financing immediately (DIP facility) and do a rights offering for a new $500m secured note. The initial DIP facility financing and a large portion of the $500m new secured note would be underwritten by an "Ad Hoc" group (only their law firm names given).
The current scheme of arrangement sets out the equity division of the new company as:
32.5%: revolving credit facility providers
34.8%: bondholders (who also get subscription rights to the new $500m secured note)
30%: allocated to the subscribers in the new $500m secured note
2.7%: underwriters of the new $500m secured note (mostly the Ad Hoc group + potentially some of the other bondholders based on min acceptance conditions detailed below)
0.01%: existing equity shareholders...
Additionally the "Ad Hoc" group gets some juicy compensation for providing the $500m DIP facility and first line underwriting of the secured note. They receive:
10% ($50m) of the $500m secured note in additional secured note
4% ($40m) of the $500m rebated in cash
I'm guessing the "Ad Hoc" group includes some or all of their current largest active shareholders: Luminus, Contrarius and Odey and they're also the 50% bondholders who have already come to agreement. It would explain why Valaris took time to declare Chapter 11 (they needed time to buy the bonds since they can't act after becoming privy to insider information after the scheme is agreed on). This makes the equity vote in favor of the scheme likely.
They've created incentive for other bondholders to agree and join the underwriters: if >46% of the yet to agree bondholders (so an additional 23% of the total bondholder pool) agree to the scheme AND join the underwriting party within the next 15days; they share (alongside the "Ad Hoc" group) in the 2.7% equity interest and the exclusive underwriting rights to 37.5% of the new $500m secured note (while still maintaining pro-rata participation rights in the remaining 63.5%).
A simplified pre and post scheme balance sheet (based on June 30, 2020 financials):
The important things to note are:
Post restructure, VAL will have$1.2bn cash liquidity with net cash of $132m. Additionally I believe the banks will extend a new revolving credit line to the company
Net PPE has already been written down from $15bn 12/2019 to $11bn today
Approximately $250m in future payments commitment for two new rigs is wiped out (the guarantor was a VAL subsidiary which will likely be closed). I doubt they'll renew the commitment post Chapter 11
The negative free cashflow is probably -$500-700m pa in today's type environment. I think the new cash runway, with no new financing, is probably ~2years. But even a restructured company like this can gear to at least 30% P/B which translates to ~$3.5bn in additional debt (it's likely a new revolving credit line of $1-1.5bn will form part of this). This gives another 5-7yrs on top of the 2yrs, total 7-9yrs, which is more than enough to ride out out the cycle.
Remember the original thesis for offshore oil-rigs was:
Offshore drilling is an essential part of global oil & gas production (25-30% of the total). The production costs is competitive and cheaper than most unconventional sources e.g. CNOOC (mostly shallow water) is ~$25/bbl up to ~$50/bbl for harsh deep-water
Normal global oil demand is growing at 1-2% pa (even as European and US demand falls)
Oil-rig supply has been severely depressed since 2016. New orders are basically zero, oil rigs are being scrapping or put into hibernation en-mass. Total rigs (land and water) are at a historical low - see below. Current drilling is not enough to sustain future demand
The cycle was already turning upwards in 2019 and E&P companies were increasing capex budgets realising they couldn't replenish their reserves and maintain production otherwise. But the sudden oil demand collapse combined with overleveraged balance sheets saw even the biggest companies get blown out of the water. The natural attrition of oil-rigs and consolidation within the industry process was suddenly accelerated like the meteorite that wiped out the dinosaurs.
Although VAL was stupid and aggressive with their M&A in the wrong part of the cycle, they are one of the largest players with some of the best assets in the world. This restructuring removes the survival risk. I think many other companies won't be nearly as lucky and I expect bankruptcies, asset disposals and scrapping to continue for sometime yet. But supply and demand will and must balance one day.
Conclusion
The 30% equity attached to the new $500m secured note is the best value part of the restructure. But for conservatism assume existing bondholders fail to become underwriters. In this case they get 34.8% converted equity and have subscription rights to only 67.5% of the secured note. Based on their ownership of the new VAL, their implied equity value is roughly 98% of the value of their existing bond claims. This rises to 120% if they get full subscription rights to the new secured note.
VAL's bonds today are trading at just 5-7% of par value.
The scenario table below (using 67.5% subscription rights to the new secured bond) shows return outcomes with realisation likely over 2-4yrs. You don't have to believe in the Asset values (or be optimistic about the cash burn rate) but paying <20% of the current bond par value seems like an extremely favorable asymmetric risk/reward payoff.
I've been buying since Thursday at 5-6.x% of par value. Unfortunately these bonds are very thinly traded so its hard to get volume. Interestingly on Friday someone has been bidding against me (every price I enter they add 1c extra) but still managed to get some volume at 6-8% of par.
Spirit Aerosystems
I briefly wrote about them in an April post:
After bottoming at ~$16 in mid May, SPR surged to ~$37 in early June before steadily declining back to $19.9 yesterday. The current market cap is ~$2.1bn and at the end of June they had Net Debt of $1.5bn ($1.9bn cash and $3.4bn debt).
The news has been consistently grim with a steady decline in Boeing 737Max shipset orders from delivery cut to 216 (for all of 2020) in Feb, to 125 in May and finally just 72 in mid June. In mid 2019 SPR was producing 52/month and expecting to increase to 57/month before year end. What a difference a year makes! Boeing is currently guiding just 31/month in 1H2022 (SPR says they will be slightly cashflow positive at this level).
The first question to ask is: will orders recovery? I think the answer is clearly yes:
Global passenger aircraft number is: ~21,000. The average US commercial aircraft age is 11yrs which equates to an estimated replacement number of planes of 1,900 pa globally. Of course planes can and will be used much longer but also remember air travel demand is rising at mid single digits. Most forward projections I've seen estimate it at ~1,800 new planes each year
The commercial aircraft market is a duopoly between Boeing and Airbus. SPR is the biggest supplier to both (SPR accounts for ~20% of all global aerostructure production) and delivers ~600-800shipsets to Boeing each year (note the main profit engine is the 737). See historical production below
SPR is the exclusive supplier to Boeing for majority of their aircraft fuselage and wing systems. These contracts extend all the way to 2030s. SPR is also the main supplier to Airbus for wing systems for A320, A330 and fuselage+wings for A350
The balance of evidence suggests current production levels is a temporary situation. Boeing still has 3500-4100 order backlog (the range depends on contract likelihood) for 737Max which will likely proceed once the design fixes are implemented. In a normal year of production, SPR should make $500-600m in profits (and similar amount in free cash flow)
The second question to ask is: can SPR survive to see cash breakeven or better? The answer here is not as clear. The important things to note are:
Liquidity: SPR has sufficient cash on hand ($1.9bn) to cover their near term debt due. The company was smart and raised $1.2bn in mid April 2020 (the 2025 senior note) at a reasonable 7.5% fixed rate. In their 2Q2020 call the CFO said SPR has sufficient liquidity for the next 12months even if the acquisition of Bombardier and Asco aerostructure businesses go ahead (total cost $1bn). These contracts were signed last year and are still undergoing regulatory review
Banking covenant relief until 2022 (but at the same time their revolver is reduced to $500m which isn't much more than current borrowings)
Cash burn: their 1H20 free cashflow (FCF: operating cashflow less capex) was -$610m. However it's important to note that -$420m was mostly one-off and due to falling production impact on working capital (they have to pay their suppliers for past orders even as deliveries to Boeing fall). Accounts Payable is already half of 2019 levels at $500m today whilst Inventory is actually a few hundred million higher at $1.2bn. I estimate the working capital could have a further (one-off) -$100-200m impact but likely to positively add to FCFs in 2021 when orders rise again. In a worst case scenario SPR could see -$500-700m FCFs over the next 1yr
Significant cost cuts: $1bn costs removed since start of 2020 (40% of non-material costs). Mostly labor (44% workforce redundant and rest on 4day weeks) as well as efficiency related (consolidated sites and re-configured production lines). SPR believes they can now achieve the same 16.5% operating margin at 40shipsets/month production as they were getting at 55shipsets/month last year. I doubt there is further juice to squeeze from costs
Under current Boeing production planning SPR expects to be cash positive by 2022 (breakeven 1H and positive 2H). If the Bombardier and Asco acquisitions don't proceed I think it's almost certain SPR will be ok as it adds another 2yrs to their cash runway. But more likely than not, these acquisitions will be approved (deadline 10/2020) which makes it more difficult to assess.
Conclusion
SPR is a high quality company whichever angle you look at it: a) high barriers to competition (irreplaceable technology, manufacturing know-how, exclusive supply contracts), b) excellent operational management (cost control, relationships with Boeing and Airbus), c) great capital allocation history (bought back $2.5bn worth of shares reducing share count by >25% over the past 6yrs). The industry is in a temporary slump and the likelihood of recovery is extremely high. But the biggest risk to investing in SPR equity is the capital structure gets upended in a VAL type reshuffle.
I think the fair value for SPR is at least 15x normal earnings which puts it around $7.5bn or ~$72/share or 3.6x current share price. Using this, the Expected Return (using 0 as the lower bound) is breakeven at just 28% survival rate. I believe SPR's chance of surviving (without restructuring) is well above this level. Also, difficult to estimate directly, but I think sentiment adds further % points to the survival rate: a vaccine and recovery in air travel will likely see big bounces in this type of company which usually opens up capital markets. This makes SPR an excellent bet in my view.
VAL and SPR in a portfolio
These are binomial asymmetric payoff plays which is very different to the compounding returns profile of an investment like JD.com. Whilst in the latter case I'm comfortable letting the position grow to teens to 20% of my portfolio (provided there is a lot of fat between current price and my initial entry price), for VAL and SPR one has to manage the risk allocation carefully - they could go to zero.
This is a classic wealth allocation problem which ultimately depends on the risk/return profile and objectives of the investor. In my case, I think the right answer is somewhere around 2-4% each. If I had more similar ideas, then the % would reduce such that the total allocated to these plays doesn't exceed mid to high single digits of my portfolio.
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